After a Brief Break, Here’s A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I’ve posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday’s closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck’s dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

I’ve been puzzling over the mechanics of the SGP preferred in this transaction.

Does Merck pay preferred holders $10.50 x the conversion rate when the merger closes, when the mandatory conversion takes place, or does the conversion ratio adjust so the entirety of the SGP preferred converts to Merck common in August 2010?

The $10.50 cash + 0.57 share ratio is only for SGP common shares at closing of the merger. The SGP preferreds have an entirely different conversion ratio (all stock, no cash) which is based on where the common is trading in August 2010 and was determined when the preferred were first issued.

Essentially, the only thing that is changing regarding the preferred due to the merger is the underlying stock it represents (SGP convertible preferred will become MRK convertible preferred, but the original terms will remain the same).

In your response to the first comment you describe in general terms how the preferred converts in the absence of an acquisition. There is a procedure in the prospectus for conversion with an acquisition and it is different than the August 2010 conversion.

In addition, you did not mention that if the SGP averge price exceeds $27.5 for any 20 days then the number of common shares in the conversion option decreases. If the price exceed $33.5 you would only be able to convert into 7.4206 shares which makes the preferred worth only $175 and change at this morning’s price.

With an acquisition, this security does not just turn into a MRK preferred as you stated. There is a specific procedure in the prospectus referred to as a “Make-Whole Acquisition Conversion Rate”. This provision would have an acceleration of dividend payments but convert the stock at an inferior rate. Depending on when merger occurs and stock price at time of closing this could work out better or worse than normal conversion.

The Merck/Schering deal is legally structured as a reverse merger, not an acquisition of SGP by MRK. I suggest you read the merger agreement. Schering is actually the surviving corporation in this deal, with all Merck shares being converted on a 1-for-1 basis into Schering shares and the corporation name will be changed to Merck.

You are correct that the par value of the preferred is $250, which affects the conversion ratio of the preferred, but since it is trading at $210, I would be happy to accept $250 in stock plus $20+ in dividend payments on a $210 original investment.

Frankly, I would probably close out the trade after the merger closes anyway, so the conversion details aren’t that crucial anyway.

In reading the SGP-pB prospectus it doesn’t appear to me to make a difference what the surviving entity is, the “Make-Whole Acquisition Provision” would be triggered. I am not a lawyer but the wording seems pretty clear to me.

As to the $250 plus dividend notion I never mentioned the par value in my comment. This is a mandatory convertible, you don’t get $250/share under any circumstances. You get common shares in an amount determined by the share price on the August 13, 2010 conversion date. The conversion numbers from my previous post would all be as stated if the “Make-Whole” Provisions are not triggered.

You may intend to sell after the merger closes but the price of the security you are selling will still be determined by its ultimate value as specified by the mandatory conversion provisions. If the conversion amount changes based on the SGP common price how much MRK are you going to short? SGP-pB is worth between 9.0909 and 7.4206 shares of SGP common and you really don’t know what the number is going to be at the time the merger closes. If the “Make-Whole” provisions are triggered then it will definately be worth less than 9.0909 common shares.

I am not trying to give you a hard time, I am trying to figure out if there is an interesting trade here and it not a simple or straightforward arbitrage.

I’ll make a deal with you, I’ll read the merger prospectus and you read the mandatory convertible preferred prospectus.

Fair enough. The way I read it, all it says is that you may have to convert early if SGP is acquired. You are right that the conversion ratio is slightly less in an early conversion, but you also get the present value of the dividend payments that you would miss out on by converting early, so that should make up the difference.

You didn’t mention the par value of $250, but that is how the conversion rate is determined ($33.69 per share times 7.42 shares is $250), so if the stock is $33.69, you would get $250 in stock.

Regardless of when you have to convert (I do not believe they are going to force early conversion, based on the merger agreement language) I don’t see how it would affect the trade I am outlining, which is trying to capture the 9.4% spread on the deal. Since MRK’s common dividend is higher than SGP’s, using the preferred rather than the common for the arbitrage actually increases the 9.4% return slightly, rather than decreading it slightly, which would occur from paying out more in dividends than you receive.

As for which conversion rate I would use, I would use the 9.1 conversion ratio because SGP is trading at $23 or so. I don’t expect it to trade outside of the $20-$25 range, but even if it goes to $15, the MRK short would make a ton. Conversely, if SGP goes to $35, the MRK short loses money but the SGP preferred would be worth $260 plus dividends. Regardless, I don’t see how this trade loses if the deal closes, but if you do let me know.

The merger agreement refers to Section 10 Annex A of the Certificate of Incorporation which is the stuff about the Make-Whole acquisition I referenced earlier as to the treatment of the convertible preferred.

If the preferred does not convert at merger closing I don’t know what the underlying security would be going forward. You seem to think it would be the new Merck, that doesn’t make much sense to me. It might be the same certificate of incorporation but it is a completely different security. If MRK (new Shering Plough)is the new underlying post merger for the convertible then it is trading at a much bigger discount than you indicate in your post. You would be getting 9.0909 shares of MRK which is currently worth about $242. I think this is pretty unlikely. If you don’t know what the underlying common equity security is you cannot price the mandatory convertible.

As to how you could loose money. If at the inception of your trade you buy 1 share of SGP-pB and short 5.243 shares of Merck(the proper hedge ratio from the merger combined with the 9.0909 per common share for the preferred) you would have the following P/Ls at deal close with various MRK stock prices:

As you can see somewhere around $30 for SGP stock price (about $34 for MRK) the deal goes negative, exclusive of the small dividend differential. The problem is as the SGP price rises above $27.50 you start receiving fewer common shares to cover your MRK short with. You have no issue with a drop in common prices because the exchange ratio is already as low as it can go.

If the preferred converts at deal close the hedge P/l is worse across the board but you get a couple quarters of accelerated dividends.

I get different numbers when I use your example of MRK at $34.00 and SGP at $30.11 and a ratio of short 5.25 MRK shares for each share of SGP-PB owned.

Let’s say I buy 4 SGP-PB at $210.55 and short 21 MRK at $26.67 (those were Friday’s closing prices).

If MRK goes to $34 the short position loses $153.93 ($7.33 x 21). In that case SGP-PB is worth $250 (8.3 x $30.11), so the long position earns a profit of $157.80 ($39.45 x 4). Assuming a 12-month holding period, the net dividend income is another $28, so the total profit from the trade is about $32.

You are right that the deal does go negative at some point if Merck skyrockets, but I’m not really worried about Merck heading to $40 or something like that, which is a 50% gain from current levels. On a risk-reward basis, this is still a very conservative trade.

Thanks for all the discussion yesterday. I did some more work on this also.

If the deal closes when MRK common is at $34, that implies SGP common acquisition value of $30.1078.

If the close is on 12/31/08, the make-whole conversion table on page 53 of the charter would entitle an SGP-pref holder to 8.052328 shares of SGP common, which would be worth $242.44, of which $84.55 is cash and the balance is 4.643778 shares of MRK common. One would also get around $10.90 in present-value-of-2010-preferred dividends plus the 2009 dividends from here to 12/31/09.

Shorting 5.25 MRK common for every SGP-pref and then having Merck close the deal with MRK common at $34 on 12/31/09 implies a 31.16% IRR according to my numbers. However it goes negative just north of $38 for MRK common.

No problem, it was a solid discussion. I’ll trust your numbers. A breakeven point of $38 MRK sounds good… I threw out $40 as an estimate so I was close. Since the merger agreement says the preferred will remain outstanding after the deal, I don’t think early conversion is an issue, but even if it is, it doesn’t matter unless Merck soars. For those of us who follow the stock, there would be no reason for that to happen.. it was in the low 20’s when they announced the deal.

You will not be compelled to convert although the make-whole option makes early conversion more attractive than it would be in the absence of a merger.

As a follow-on, if you decide to hold the SGP-pref after the merger, it will be convertible into MRK common in an amount that depends on the price of common just as it does now as described in the preferred prospectus. Accounting SGP IR yesterday, a new table listing the new conversion ratio will become available after the deal closes (as that’s as soon as the actual ratio between the two common stocks will be known for certain).

Seems to me if one were seriously concerned about the risk of MRK common exploding to the upside, relatively cheap very out of the money call options could be used to protect against that.

Robert,
Your idea doesn’t quite work the way you outlined it. You can certainly arbitrage SGP with SGP preferred (lots of arb hedge funds do this with convertible securities), but the spread is not as wide as you indicated because you used the price of MRK, not SGP in your calculation.

Given the deal in place, MRK will eventually trade equal with SGP but you can’t assume SGP will rise to Merck’s price because Merck could just as easily trade down to where SGP trades, which negates your arbitrage.

Therefore, to capture the deal spread you need to work MRK into the trade somehow. The spread on a conventional convertible arb with only SGP is lower (1-2% plus the dividend differential of 5.7%)

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